Commuters
on a public bus in Lagos, Nigeria.Akintunde Akinleye/Reuters

Nigeria has plenty of examples of how this can spiral out of
control.

In Thailand, the depegging of
the currency triggered financial mayhem that spread, causing the
Asian financial crisis.

And in Argentina, a peg was
actually established to combat inflation that was so rampant that
supermarkets were forced to read out prices over a loudspeaker to
keep up.

Still, most analysts and
economists argue that Nigeria did the right thing — that a
de-pegged naira is good for the country in the longer
term.

In order to understand why that
is, you have to understand what a currency peg actually is,
and why countries would manipulate markets to keep exchange
rates stable.

Holiday plans?

So,
you want to go to London? Better check the exchange
rate.REUTERS/Toby
Melville

If you had been planning a trip to England on, say, June 23, you
might have looked at some hotels, shows in the city's West End,
and train fares to Stonehenge and found that all that fun
will cost you about 1,000
pounds.

A currency converter would
show that those thousand pounds will cost you $1,480.

Then, Brexit happens. British voters unexpectedly choose to leave
the EU. Overnight, the value of the British pound plummets and
all of a sudden that $1,480 trip will cost you $1,390.

A few days later, it has dropped
to $1,290, and it seems like everyone is booking those London
holidays.

Here's what this change looks
like to a currency trader. The line is jagged because the value
fluctuates nonstop:

Investing.com

This is how most currencies work.
Their values rise and fall depending on what's going on in the
world, the expectations of the strength of the underlying
economy, and whether traders are buying or selling.

But a currency peg is different

Simply put, the term "currency
peg" describes when one currency's value is fixed to another's.
It's like they've been tied together with a rope. Where one goes,
the other follows.

What this actually means, in
economics-speak, is that a country's central bank artificially
controls the value of its currency.

This makes things more predictable. Consider, instead of London,
a vacation to Dubai — to see an indoor
ski slope and some unbelievably tall buildings.

The dirham, the local currency,
is pegged to the US dollar at the rate of 3.67 dirhams. It means
that a $1,000 trip to Dubai will cost the same in a week, a
month, or a year — no matter what happens in the US, the United Arab Emirates,
or the world economy.

Here's what a currency peg would look like on a chart, featuring
the Nigerian naira. Notice that, unlike with the pound against
the dollar, the line on this chart is straight — until the nation
finally broke the peg in June:

OK, so why would a country peg its currency?

Here are some reasons:

It makes trade more
predictable. If you rely heavily on exports
— like a major oil producer does — then pegging your
currency to another helps ensure neither you nor others have to
worry about the exchange rate going up and down.

It helps countries with low costs of production keep
exports cheap. Basically, when times are good,
the peg keeps the currency artificially cheap.

To help address the
problem of skyrocketing prices, which is called
"hyperinflation." A peg can bring back stability if the local
currency is fixed to a relatively stable currency like the euro
or the dollar.

But as we'll learn, pegging means
giving up a lot of control and can lead to its own
problems.

How does a peg work?

Obviously, you don't literally tie one currency to another.
Rather, a country has to, in effect, offset the effects of the
market by artificially controlling supply and demand for its own
currency.

A widely watched currency
peg is Hong Kong's. The Hong Kong Monetary Authority keeps a
watchful eye over the value of the Hong Kong dollar, which is
pegged to the US dollar, and if it sees heavy demand — like
before a big initial public offering in the city — then it will
start selling Hong Kong dollars.

It's the central bank, so it can
just release more of its currency into the market and dampen its
value.

In the opposite instance, where
people are pulling money out of Hong Kong and selling Hong Kong
dollars, the central bank taps its reserves and starts to
buy.

In both cases, this offsets
the effects of the market.

But things can go wrong

There are several problems that
countries can run into if their currency is pegged, including but
not limited to:

Pegs mean a central bank loses control over some basic
policy making. Interest rates in Hong Kong, for
example, have to follow interest rates in the US, set by the
Federal Reserve. It became a problem recently when the US was
suffering through the great recession, but Hong Kong was
enjoying a boom thanks to China's growth. While the central
bank would've liked to have seen higher interest rates to keep
inflation down, it was forced to keep them low.

Central banks need to hold a lot of foreign
currency to keep the peg going. Central banks need a
huge amount of reserves to maintain the peg, but these
reserves can also lead to higher
inflation. And — as you'll see below — when they run out of
those reserves, chaos can ensue.

Pegging could incentivize the creation of a black
market. An official peg may be something like
3 pesos for every dollar, but if there aren't enough
dollars, then you might find "unofficial" exchange rates on the
street far different than the official peg. You might have to
pay 6 pesos to get a dollar. That black-market price gives
you a sense of what the exchange rate would be if the currency
were not artificially fixed.

The Thai baht's peg and the Asian financial crisis

A
bank employee changes the rate of foreign currencies outside a
bank in central Bangkok on January 5. Thai markets began the new
year with a hangover as the Thai baht crumbled to a record low
onshore and the stock market took another pounding. The baht has
now lost almost 50% of its value against the American
dollar.Reuters

Arguably, the most infamous
example of a recent fixed-exchange rate is the Thai baht, given
that the government's decision to de-peg it from the dollar
precipitated the Asian financial crisis in the late 1990s.

But things started to slow down
around 1996, which then put some pressure on the government to
devalue the currency. It resisted for some time, but when
investors started betting that the currency would lose
value in 1997, this prompted the Bank of Thailand to spend
billions of dollars of its limited foreign reserves defending its
currency.

Employees
of suspended finance companies during a rally outside the Bank of
Thailand in Bangkok on November 12. Hundreds of disgruntled
employees who were either laid off or about to lose their jobs
urged the central bank to take responsibility for their
plight.Reuters

The depreciation of the baht was followed by a chain reaction of
people speculating against other Southeast Asian currencies,
including the Malaysian ringgit, the Philippine peso, and the
Indonesian rupiah. By fall 1997, the turbulence then spread to
South Korea, Hong Kong, and China. And then, in 1998, it spilled
into Russia and Brazil.

"It is apparent in hindsight that this dilemma could have been
avoided by allowing the currency to appreciate during the earlier
period of capital inflows, when there was no threat of a sudden
loss in value in the currency," argued
Ramon Moreno, at the Federal Reserve Bank of San Francisco.

Domingo Cavallo was the guy who had to try to solve this. As
minister of the economy in 1991, he came up with a plan known as
"Covertibilidad" — or "convertibility." It pegged the Argentine
austral — now called the peso — at 10,000 to the dollar.

Over the short-run, the strategy worked and helped bring
inflation from
2,314% per year in 1990 to 4% by 1994. But, eventually,
Argentina ended up running into the negative effects of having a
fixed-exchange rate.

Unemployed
Argentines demand food at the gate of a supermarket on the
outskirts of Buenos Aires on December 19, 2001. Police in riot
gear fired tear gas and rubber bullets to disperse looters who
ransacked shops and supermarkets in the capital and northern part
of the country, in some of the worst rioting in more than a
decade.Marcos
Haupa/Reuters

This was evident when the Asian financial crisis bled into
Brazil, and the
Brazilian real plunged. The peso, still linked to the dollar,
did not. This left Argentine exports significantly more expensive
relative to those of Brazil, taking a toll on Argentina's economy
and making it harder for the government to repay its debts.

"Lower export takings have limited the country's ability to earn
the foreign currency needed to repay dollar-denominated debts,"
reported the
BBC. And "a decline in world prices for farm product, and the
global economic slowdown of recent months, only worsened
Argentina's problems."

Argentine
riot police watch thousands who took to the streets to demand the
resignation of President Fernando de la Rua, in Buenos Aires on
December 20, 2001.Marcos
Haupa/Reuters

"The obvious solution, a
devaluation, is a non-starter. Less than a tenth of the
government's debt is denominated in pesos, so devaluation would
bring financial ruin to it as well as to private-sector
borrowers. A big refinancing early this month of $29
billion-worth of commercial debt, through a swap for longer-dated
bonds, bought a respite. But the shadow of a potentially
catastrophic default still hangs over Argentina."

And so, things got worse. Eventually, the government enacted the
"corralito"
in November 2001, which froze bank accounts and allowed
withdrawals of only
$250 per week.

Riots escalated across the
country in response in December 2001.

Argentine
demonstrators place tires to block a main avenue to protest
unpopular new banking curbs, soaring unemployment, and economic
austerity measures in Buenos Aires on December 14,
2001.Enrique
Marcarian/Reuters

Ultimately, the government was
left with no choice but to de-peg its currency from the dollar in
January 2002.

"The currency board [which managed the peg], although it
initially played an essential role in achieving disinflation, was
an inherently risky enterprise; it changed over time from being a
confidence-enhancing to becoming a confidence-damaging factor, as
the policy orientation shifted from a 'money-dominant' to a
'fiscal-dominant' regime," the International
Monetary Fund noted.

The Nigerian naira and the collapse of oil prices

People
line up with their vehicles to buy fuel in front of a station at
in Lagos on April 5, 2016.Akintunde
Akinleye/Reuters

The last couple of years saw
oil prices collapse from about $100 a barrel in June 2014 to
around $40 to $50 a barrel in the second quarter of 2016.

Nigeria, an OPEC member and one
of the world's biggest oil producers, heavily relies on the
commodity.

The country pegged the naira to the dollar a few years ago to
help stabilize the currency. But amid lower oil prices, the
Central Bank of Nigeria had to spend about 20% of its foreign
reserves defending the peg from late 2014 to June 2016, according
to figures from the bank,
which were cited by The Wall Street Journal.

Central
Bank governor Godwin Emefiele during the monthly Monetary Policy
Committee meeting in Abuja, Nigeria, on January 26, 2016.
Nigeria's central bank kept its benchmark interest rate at 11%
and left the naira exchange rate fixed despite a dive on the
parallel market and complaints from businesses struggling to get
dollars for imports.Afolabi
Sotunde/Reuters

Economists and analysts had long
been arguing that Nigeria will eventually have to capitulate and
devalue its currency, given that the government'scontroversialagenda of currency and price
controls exacerbated economic stresses in its economy.

Finally, in June 2016, the
Central Bank announced that it would abandon its peg of 197 to
198 naira per dollar. When trading opened on the day of the
devaluation, the currency collapsed to by about 30% to over 280
per dollar.

Plus, inflation spiked in the
aftermath, which prompted the central bankto hike ratesup to 14% from 12% in July in
order to avoid a cycle of rising inflation and a weakening
currency.

"This is one reason why
devaluations can be so painful, as central banks typically jack
up interest rates afterwards. Recessions are often seen
post-devaluation," Marc Chandler, the global head of currency
strategy at Brown Brothers Harriman, said in a note in
June.

Nigerian
fuel marketers agreed to resume distribution on after weeks of
disruption led to chronic fuel shortages, bringing phone
companies, banks and airlines to a standstill days before the
inauguration of the country's new president last
year.Afolabi
Sotunde/Reuters

But although the situation
has gotten ugly in the short term, things should eventually start
to pick up.

"Over the long-run, a weaker
currency will help Nigeria's economy by encouraging import
substitution and attracting foreign investors, who have shunned
the country for fear of a devaluation," wrote John
Ashbourne, Capital Economics' Africa economist, in a
note in June.